“Banks will no longer be allowed to own, invest [in] or sponsor hedge funds, private equity funds or proprietary trading operations for their own profit, unrelated to serving their customers … I’m also proposing that we [the US government] prevent the further consolidation of our financial system”. With these words, President Obama signalled that his administration would significantly intensify its attack on Wall Street and was determined to change the system. His proposed rules – which would come on top of other reforms currently being considered by the Basel Committee – have sparked a furore in the media and appear to have caught banks on the hop. It is clear that these rules could potentially hit banks’ profitability hard. However, given the lack of detail set out so far, it is hard to gauge their full impact if they are enacted by Congress – which is itself far from certain, given that the Democrats have just lost their filibuster-proof majority in the Senate and many Republicans could well object to the move.

While the mooted ban on prop trading is the big headline grabber, its impact on bank profitability is likely to be limited. Banks have been scaling back their activities in this area, so that even Goldman Sachs only derives around 10% of its revenues from this activity. But the regulators’ definition of prop trading is yet to be defined, and it remains to be seen whether Obama will broaden his attack to include more risky client-driven activities (such as hedging a client’s position with the bank’s own funds) as a means to cut wider systemic risk.

In any case, it is likely that any move to force banks to sell their profitable private equity operations and hedge funds would be of greater consequence than restrictions on prop trading. However, there is also a lack of clarity surrounding these proposals. While it seems that private equity funds would almost certainly have to be divested under the current scheme, banks may be allowed to keep managing their hedge funds as long as their own capital is not at risk, allowing them to continue raking in large fees. The suddenness with which President Obama introduced his plan and its lack of detail have generated a great deal of uncertainty about the package. What we can say, though, is that banks would be affected to differing degrees according to their business models, as set out in the table below.

How Obama’s proposals hit US banks

Source: Wall Street Journal

There is one more crucial question to answer. When President Obama said “banks”, did he mean it in the strict regulatory sense (i.e. bank holding companies that take FDIC-insured deposits) or systemically important financial institutions that have an implicit taxpayer guarantee? If the former, then Goldman Sachs and Morgan Stanley may be able to avoid any new rules simply by giving up their recently acquired bank holding company status. But such a move would run counter to logic, as they are clearly risky institutions that cannot be allowed to fail. Finally, it is not clear whether US subsidiaries of foreign banks would be affected, although the President's recent tax proposal makes it likely that they would be.

All in all, Obama's sudden proposal has taken everyone by surprise and requires substantial fleshing out before its full impact will be known. But what is clear is that the US authorities have over the past week cemented their intention of bringing serious reform to Wall Street.

Nick Smallwood, Credit Analyst

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